Western central bankers are convinced reflation and economic growth are finally underway as a result of their $14tn stimulus programmes. But the best leading indicator for the global economy – capacity utilisation (CU%) in the global chemical industry – is saying they are wrong. The CU% has an 88% correlation with actual GDP growth, far better than any IMF or central bank forecast.

The chart shows June data from the American Chemistry Council, and confirms the CU% remains stuck at the 80% level, well below the 91% average between 1987 – 2008, and below the 82% average since then. This is particularly concerning as H1 is seasonally the strongest part of the year – July/August are typically weak due to the holiday season, and then December is slow as firms de-stock before Christmas.

The interesting issue is why these historically low CU% have effectively been ignored by companies and investors. They are still pouring money into new capacity for which there is effectively no market – one example being the 4.5 million tonnes of new N American polyethylene capacity due online this year, as I discussed in March.

The reason is likely shown in the above chart of force majeures (FMs) – incidents when plants go suddenly offline, creating temporary shortages. These are at record levels, with H1 2017 seeing 4x the number of FMs in H1 2009.

In the past, most companies prided themselves on their operating record, having absorbed the message of the Quality movement that “there is no such thing as an accident”. Companies such as DuPont and ICI led the way in the 1980s with the introduction of Total Quality Management. They consciously put safety ahead of short-term profit and at the top of management agendas. As the Chartered Quality Institute notes:

“Total quality management is a management approach centred on quality, based on the participation of an organisation’s people and aiming at long-term success.”

 Today, however, the pressure for short-term financial success has become intense
 The average “investor” now only holds their shares for 8 months, according to World Bank data
 This time horizon is very different from that of the 1980s, when the average NYSE holding period was 33 months
 And it is a very long way from the 1960s average of 100 months

As a result, even some major companies appear to have changed their policy in this critical area, prioritising concepts such as “smart maintenance”. Such cutbacks in maintenance spend mean plants are more likely to break down, as managers take the risk of using equipment beyond its scheduled working life. Similarly, essential training is delayed, or reduced in length, to keep within a budget.

ICIS Insight editor Nigel Davies highlighted the key issue 2 years ago as the problems began to become more widespread around the world:

“The situation in Europe has exposed underlying trends and issues that will need to be addressed. Companies appear not to have sustained an adequate pace of maintenance capital expenditure. That has been for economic as well as structural (cost) reasons. Spending in high feedstock and energy cost Europe has certainly not been considered de rigeur….Having maintained plants to run at between 80% and 85% of capacity, suddenly pushing them hard does little good. Sometimes, they fail.”

The end-result has been to mask the growing problem of over-capacity, as plants fail to operate at their normal rates. This has supported profits in the short-term by making actual supply/demand balances far tighter than the nominal figures would suggest. But this trend cannot continue forever.

THE END OF CHINA’S STIMULUS WILL HIGHLIGHT TODAY’S EXCESS CAPACITYThe 3rd chart suggests its end is now fast approaching. It shows developments in China’s shadow banking sector, which has been the real cause of the apparent “recovery” and reflation seen in recent months:

 Premier Li began a major stimulus programme a year ago, hoping to boost his Populist faction ahead of October’s 5-yearly National People’s Congress, which decides the new Politburo and Politburo Standing Committee (PSC)
 Populist Premier Wen did the same in 2011-2 – shadow lending rose six-fold to average $174bn/month
 But Wen’s tactic backfired and President Xi’s Princeling faction won a majority in the 7-man PSC, although the Populist Li still had responsibility for the economy as Premier
 Li’s efforts have similarly run into the sand

As the 3-month average confirms (red line), Li’s stimulus programme saw shadow lending leap to $150bn/month. Unsurprisingly, as in 2011-2, commodity and asset prices rocketed around the world,funding ever-more speculative investments. But in February, Xi effectively took control of the economy from Li and put his foot on the brakes. Lending is already down to $25bn/month and may well go negative in H2, with Xi highlighting last week that:

“China’s development is standing at a new historical starting point, and … entered a new development stage”.

“Follow the money” is always a good option if one wants to survive the business cycle. We can all hope that the IMF and other cheerleaders for the economy are finally about to be proved right. But the CU% data suggests there is no hard evidence for their optimism.

There is also little reason to doubt Xi’s determination to finally start getting China’s vast debts under control, by cutting back on the wasteful stimulus policies of the Populists. With China’s debt/GDP now over 300%, and the prospect of a US trade war looming, Xi simply has to act now – or risk financial meltdown during his second term of office.

Prudent investors are already planning for a difficult H2 and 2018. Companies who have cut back on maintenance now need to quickly reverse course, before the potential collapse in profits makes this difficult to afford.

China’s polyester industry, like many others, is already preparing to shut down ahead of September’s G20 Summit in Hangzhou, to reduce pollution levels. The phenomenon even has its own Wikipedia page, APEC Blue, to describe the moment in November 2014 when Beijing suddenly saw blue sky for the whole of the Asia-Pacific Economic Co-operation (APEC) summit meeting. It is defined as being “something wonderful, but fleeting”.

China’s leaders want blue sky again for the G20 leaders. But you can’t continue to run the world’s second largest economy like this. Hangzhou is China’s 4th largest city, 200km (125 miles) from Shanghai, and is home to 21m people. And yet, as Lloyds Loading List reported in March:

“Exporters and importers from China’s Pearl River Delta brace for supply-chain disruptions as factories prepare for partial and complete closures in advance of September’s G20 Summit in Hangzhou…factories could reduce or cease production starting as early as June. With the Summit not opening until September, importers sourcing from the Shanghai area could face a summer of supply chain disruption.”

You have to deal with the root cause of the problems, not the symptoms.

CHINA’S POST-2008 STIMULUS LED TO CORRUPTION, POLLUTION AND THE INVESTMENT BUBBLE
And pollution is not the only super-critical issue that needs to be tackled. A blog reader has kindly forwarded the attached chart from Woodford, the respected investment fund. Under the heading Bubble Trouble, it shows the volumes traded in China’s Dalian commodity futures markets on just one day last month, 21 April:

$93bn was traded in steel rebar, $47bn in iron ore, $23bn in copper, $23bn in cotton and $11bn in PTA

China’s total imports of iron ore were 950MT in 2015: Dalian futures volumes exceeded this on 2 days in April

Readers with long memories will remember we have been here many times before, since China’s stimulus bubble began. In April 2009, the Dalian futures exchange traded 77 million tonnes of LLDPE (Linear Low Density Polyethylene), 3x total world production at the time – highlighting how the bubble was distorting world markets. Most of the speculators probably never even knew what LLDPE was, let along its supply/demand fundamentals.

The underlying cause of both problems – pollution and the lending bubble – is, of course, corruption and graft. Easy money policies make it easy for well-connected people to make vast fortunes very quickly – one, not very senior general in the People’s Liberation Army (PLA), apparently managed to build a $5bn fortune through bribery and corruption. And as Reuters reports, China’s Central Commission on Discipline and Inspection (CCDI) has discovered even the release of commodity statistics is prone to corruption:

“CCDI said last week that hundreds of staff working for the statistics bureau had been using official data for personal gain.”

Not for the first time since Xi came to power, tough decisions are being made. He has just appointed himself commander-in-chief of the PLA, an essential step to stamping out graft in the army – as Business Insider notes:

“The PLA’s officer corps has gotten deeply involved in enriching themselves. In the past, the PLA was directly involved in PLA-owned enterprises. Those have been reduced, but the PLA leadership is still intertwined with Chinese business, either directly or through relatives. The PLA’s size and influence mean that its officers’ interests are torn between the party and the wealthy now under attack.”

Xi is also moving against the Populist faction, which has been the main supporter of stimulus policies, as I noted in the Financial Times last year. Former President Hu Jintao and current Premier Li Keqiang are both Populists who came to the top via membership of the Young Communist League:

Wang Quishan, Xi’s corruption tsar, has found evidence of “embezzlement and influence-peddling”

On Thursday, state media reported the League was soon to publish a “detailed plan for its own reform”

THE COMMODITY BUYING FRENZY HAS PROBABLY PEAKED
Most long-lasting trends in financial markets normally end with a “buying climax” where suddenly everyone jumps in on the action. And it looks very likely that this is what happened in China’s financial futures markets last month. The volumes traded defy rational logic – and can only have been due to financial frenzy. As Woodford warn:

“We know from history that when bubbles burst, they do so in a damaging and unpredictable way. It is impossible to predict when and what will trigger their bursting, but it is inevitable that fundamentals will reassert themselves eventually.”

Evidence from oil markets also suggests the bubble is close to bursting. China’s so-called “teapot refineries” have been a major source of demand this year, due to their new export quotas. They have not been buying for the domestic market, but for exports – and Asian refining margins have halved since January as a result. And now the largest “teapot refinery” says even their storage is full:

“Everybody’s storage is full and it takes time to digest the inventories, maybe 2-3 months.”

Of course, many in the markets think this bubble might continue for another few months. My own view is that this underestimates Xi’s determination to sort out the problems he inherited during 2016, and “take the pain” of restructuring before he comes up for reappointment next year.

Thirdly, pollution is being tackled by literally ‘sending in the bulldozers‘ to destroy polluting factories under the eyes of TV cameras, and introducing quotas on car sales in the major cities

It is impossible to underestimate the scale of the changes now underway. Just as under Deng and Jiang, they are being led from the top by a new leadership group headed by Xi himself. Its key focus is on the “economy and ecology“, highlighting the economic and political crisis that developed during the “lost decade“.

Equally, as the blog has detailed this week, these challenges clearly mirror those faced by Jiang and Zhu in 1993, and by Deng and Zhao in the post-Mao period after 1977:

Politics
Today’s challenge is not to restore order after the chaos of the Gang of Four, or after Tiananmen Square. Instead it is to head off an existential crisis over pollution, coupled with demographic decline. The Party’s main think-tank, China’s Academy of Social Sciences, has thus headlined the “shrinking demographic dividend, overcapacity, choking pollution, risks from the property sector and local government debt“ as key threats to be tackled immediately.

Financial
Bankruptcy was the key economic challenge facing Deng in 1977. Whilst as the World Bank noted, the major risk in 1993 was that ”China could have lost economic control and landed in a Latin American-style inflationary spiral”.

This time, as a major World Bank report with China’s National Reform and Development Commission has warned:

“China’s growth is in danger of decelerating rapidly and without much warning. That is what has occurred with other highflying developing countries, such as Brazil and Mexico, once they reached a certain income level, a phenomenon that economists call the ‘middle-income trap’.”

This comprehensive Report was issued to coincide with the 5-yearly Party conference in March 2012 and highlighted 5 key risks:

“The end of export market growth; wasteful infrastructure investment; the need to boost personal consumption via higher wages (which has the downside of reducing profit margins and job creation); managing the transition to a new economic model; and the threat of hitting ‘the middle income trap’ described by Nobel Prize winner Sir Arthur Lewis”

Xi and Li follow the Deng/Jiang model
In response, it is clear that the new leadership is closely following the successful strategies developed by Deng and Jiang in response to similar crises:

The return of ‘the man who knows what to do’. Deng was brought back in 1977, having been purged 3 times, because he was the only person who could manage the situation. Similarly he returned a second time with his Southern Tour in Q4 1992 to build Jiang’s powerbase. This time it has been Jiang who returned. He ensured the removal of the corrupt Bo Xilai, and forced through the leadership changes in November 2012 that meant 6 of the 7 current Politburo members are his men

The immediate assumption of control over the military. The Bo Xilai affair highlighted the risk of military unrest – there were well-reported rumours of tanks moving in Beijing in March 2012. Xi has followed Deng and Jiang in immediately taking control of the Central Military Commission by becoming its chairman

The use of the World Bank to develop a policy framework. Again, Xi has followed Deng and Jiang in this, with no delay. In fact, the World Bank began work even before Xi formally took power – highlighting his early awareness of the depth of the crisis that China faces

Focusing on the economic challenge immediately. Deng had premier Zhao Ziyang, and Jiang had premier Zhu Rongji, both entirely focused on the economic issues. Today, Li Keqiang is taking the same role. Equally important is that Xi has followed Deng and Jiang in taking personal leadership of the issue via chairmanship of the new “Leading Group for Overall Reform”. Without his active involvement, reform will inevitably be blocked by those who would lose out as a result

Willingness to take tough measures. China’s new leadership have 10 years of power ahead of them. Thus they are already sending in the bulldozers to destroy polluting factories over the heads of local government officials. Whilst Xi’s appointee at the central bank, Zhou Xiaochuan, is taking power back from the regulators who have failed to control the shadow banking sector. All this has clear parallels with Deng and Jiang’s ‘no nonsense approach’, and their appreciation that a sense of urgency is critical for success

What does this mean for the outside world?
The years after 1977 and 1993 were stormy periods in China’s history. The period to 2020 is unlikely to be different, and there are no guarantees that the new leadership’s policies will succeed. But it is already possible to identify some of the likely major impacts on the global economy:

Domino effect. US-centric observers have wrongly assumed that the Federal Reserve’s taper has somehow begun to destabilise Asian economies such as India and Indonesia. They will now have to rush to catch up, as it becomes clear that this is really early warning of China’s massive policy shift

Double-digit growth. The imperative of political survival means the leadership have to continue to bulldoze polluting factories, and also clean up the one-sixth of China’s farmland currently contaminated with toxic waste. Therefore the days of double-digit economic growth will never return

Deflation. Premier Li made clear last year that maintaining employment was his key priority. We can therefore expect China to focus on maximising export sales during the transition, effectively exporting deflation – as volume rather than profit will be the priority.

Export Demand. China’s main export focus will no longer be the cheap textiles and plastic products of the past. Instead it will create jobs via an aggressive drive to sell affordable cars, relatively high-value chemicals and other products into Asian and developing country markets, based on its vast new capacity.

Dollar strength. China’s economic crisis will come as a shock to most of the financial community, as did the US subprime crisis. We can therefore expect China’s currency to fall in value, and the US$ to rise, all other things being equal. This, of course, will also help to boost China’s exports

Domestic Demand. Similarly the focus of China’s domestic demand will change. Sales of western luxury goods will continue to decline as the corruption campaigns continue. Instead, the focus will be affordable necessities such as $50 refrigerators for the 90% of the population who earn less than $20/

Debt. China’s record $1.3tn holding of US debt was built up as a form of vendor finance, to support US purchases of China’s products. But this strategy is no longer relevant, so we may well see China slowly reduce its holdings as it will have more use for the cash at home – putting pressure on Western interest rates

Readers will no doubt have their own insights into the impact of these changes on their own businesses and personal lives. But one thing is very clear. China not only has to go down this path, as we described in chapter 6 of ‘Boom, Gloom and the New Normal’ in November 2011. But its leaders now clearly recognise that they have to change policy with great urgency.

The blog always feared that the recent boom would turn out to be another of the ‘boom and bust’ cycles that have characterised the post-Mao period. No sane person would ever want to go back to the days of the Great Leap forward and the Cultural Revolution. It therefore hopes that Xi and Li will not only manage to overcome the current crisis, but also succeed in establishing a more sustainable future for the country.

President Jiang Zemin inherited a difficult economic and political situation when taking power in 1993, as did Deng in 1977 and current president Xi last year. Jiang had to set in motion China’s second economic cycle of the post-Mao era, or risk seeing the country fall back into poverty and the political turmoil of another Cultural Revolution.

“Former President Hu Jintao and Premier Wen Jiabao ruled China from 2002 until late 2012 …and have been accused by powerful Party figures of overseeing a “lost decade” of missed opportunities to put the country on a more sustainable path. Time is running out for the old Chinese model, based as it is on credit-fuelled property and infrastructure investment, and highly polluting low-cost manufacturing.”

If Xi does not move today, he will lose all the momentum that he has painstakingly built up over the past year. Essentially, it is ‘now or never’ for Xi and Li to act. The playbook they have followed till now is modelled on that developed earlier by Deng and Jiang, suggesting they understand what they have to do.

1993 – 2012, Jiang Zemin’s era, and its aftermath
Jiang took over as president from Yang Shangkun in 1993, having been General Secretary of the Chinese Communist Party since 1989. Like Deng, he was not impressed by ideas of democracy or political liberalisation.

His first move, after appointing Deng’s protégé Zhu Rongji as central bank governor, was to follow Deng’s 1980 policy initiative and call in the World Bank for advice. The reason was simple, as Zhu said when welcoming the World Bank team, “Foreign monks know more than local monks“.

This Dalian conference of June 1993 set out the economic programme to be adopted, with the aim of bringing China back from the abyss, and formalising Deng’s earlier dictum of the ‘socialist market economy’. The aim was simple – to keep the Communist Party in power by providing the population with increasing living standards.

Jiang inherited a number of major economic problems, as the opening up of the economy had provided wonderful opportunities for corruption to flourish. The privileges of the Special Economic Zones such as Shenzhen were being increasingly abused by corrupt leaders able to buy products and services at advantageous prices for their own personal profit. Economic disaster, in turn, was leading Party hardliners to demand a return to the ‘old ways’.

Zhu’s first objective was to resolve the enormous debts that had been built up by the powerful State Owned Enterprises as a side effect of the economic liberalisation. At the same time, he implemented extremely tight policies to bring China’s chaotic financial markets back under control. Asset prices had been allowed to rise out of control whilst corruption had flourished.

His policies led to a decade where China achieved double-digit economic growth, whilst tackling major problems of bad loans in the banking system and rising unemployment. Jiang/Zhu maintained Deng’s control over the army and his focus on raising living standards and personal consumption, and aimed to tackle the power of the SOEs via large-scale privatisations.

Equally, Deng’s policy of opening to the outside world was maintained. This encouraged the emergence of a strong export sector, which helped to support the economy through the Asian financial crisis and led finally to China’s entry into the World Trade Organisation in 2001.

The ‘Lost Decade’ under Hu and Wen from 2003-2013
However, just as with Deng’s period, these early successes were not maintained once Jiang and Zhu left power in 2003. New president Hu and premier Wen instead focused on the easy option of developing China’s role, post-WTO entry, of being the ‘manufacturing capital of the world’. The SOEs were able to regain powerful positions in major industry sectors, whilst corruption again flourished.

Then in 2008, just as in 1989, crisis intervened. Once again it was both economic and political in nature. The global financial Crisis sharply exposed China’s economic dependence on export orders, as personal consumption had actually declined since 2000 as a proportion of the economy. And so when orders disappeared in Q4 2008, 26 million people lost their jobs. Hu and Wen thus felt driven to replace this lost growth with a massive lending stimulus, as shown in the above chart.

It is fair to say that no country in history has ever undertaken such a policy on such a scale:

Official lending doubled from $719bn (Rmb 4.9tn) in 2008 to $1.5tn in 2013 (blue column). In addition, as the blog will discuss tomorrow, the banks were allowed to develop an unregulated shadow banking system that has been lending as much, or maybe more, than the official system

This temporarily rescued economic growth. Electricity consumption (red line) jumped an unprecedented 50% between 2009 and 2013. But the price was a massive increase in pollution, as factories and coal mines were allowed to cut costs by emitting toxic fumes

The lending also stimulated another boom in asset prices. Jiang/Zhu had opened up the urban property market in 1998. From 2008, easy lending policies led to major speculation, with prices rising almost exponentially as buyers panicked over being left behind

Auto sales also took off, adding more risk to the financial system, as well as more pollution in the cities. They have grown so fast, and in such an unconstrained way, that traffic jams are now an endemic part of almost any journey. Whilst pedestrians and cyclists now routinely wear masks in the major cities during days of heavy pollution

Now, as in 1977 and 1993, it looks as though the new leadership will have to pick up the pieces. As the blog described in November 2012, it is clear that the return of Jiang to a more active role was the prime cause of the changes that are now underway. The attack on corruption is a carbon copy of his earlier policy, as was the decision to bring in the World Bank for policy advice. Clearly, too, the trial of such a prominent and well-connected figure such as Bo Xilai could never have taken place without Jiang’s support.

Tomorrow’s post will therefore draw out these parallels, with the aim of highlighting the key developments that we should expect the new leadership to implement with speed. It will be a very bumpy ride, but Xi and Li know that the alternative of ‘kicking the can down the road’ would risk leading to disaster.